When it comes to debt, a 401k loan is a gray area in personal finance. These loans are not perceived as bad as credit card debt, but they also do not fit in the “good debt” category, as a low-interest rate mortgage would. So, how bad are 401k loans really? Are they a tool worth using, or should they be avoided at all costs? Here is a breakdown of why people use them and the risks to be aware of.
Key Takeaways
- 401k loans allow a borrower to access up to 50% of the account value (or $50,000, whichever is less); you pay interest to yourself, and they don’t affect your credit.
- While they may seem like an attractive option, 401k loans come with strings attached, including steep tax implications, potential tax penalties, and the loss of compound interest.
The Benefits of 401k Loans
The main benefits are generally what everyone has heard before. As opposed to traditional loans from a bank, a 401k loan borrows money from yourself. Similar to how a home equity line of credit borrows against the equity in your home, the 401k loan generally allows a borrower to access up to 50% of the account value (or $50,000, whichever is less). For example, a $30,000 account would allow someone to borrow up to $15,000. Someone with a $300,000 balance could only borrow up to the maximum of $50,000. Many people have a large portion of their wealth tied up in retirement accounts like 401ks, so having accessible funds based on your own assets can feel like an advantage compared to requesting a loan from a bank.
Next, since this loan is taken out against your own assets, technically, it means the interest on the loan is paid to you instead of a bank. By definition, a bank works by lending you money in exchange for a certain interest rate to cover the risk it is taking by loaning out the money. With a 401k loan, there is no risk of handing money to a stranger. Since you own the money in the first place, you do not have to give the interest to another company. Instead, as the loan matures, you simply pay yourself back the original loan amount plus a pre-determined interest rate.
This is why 401k loans are generally more accessible, since you do not have to involve an outside party to get access to cash. As a result, there is also no credit hit for these loans. If you default or miss a payment, the loan is not reported to the credit bureaus. To some, these loans could feel like a better way to get cash than other options, such as taking a straight 401k withdrawal instead. On the surface, the benefits sound easy to tap into some cash if you were to need it. However, don’t forget about the risks of these loans, specifically the penalties and taxes. Doing so could make certain situations much worse.
What To Be Aware Of
Arguably, one of the largest risks of a 401k loan is losing your job. Typically, 401k loans are done through your employer’s retirement plan, since that is where the 401k is physically held. For business owners, this could be less concerning since you typically can’t fire yourself. But there is still risk involved, like if the company folded, was sold, or if you need to close the 401k plan for any other reason. Regardless, leaving the company or the plan for any reason generally requires the debt to be repaid in full.
This could cause significant issues for anyone who may not have the cash to cover it. If the loan is not paid back in full, the IRS treats it like an early withdrawal, generally with penalties and taxes linked to it. If you are under 59.5, there will likely be a 10% early withdrawal penalty. Then, ordinary income taxes would apply, so someone in a relatively high tax bracket could easily see a spike in taxes.
Another major risk is the loss of potential growth of the account. Taking a loan out on your 401k means assets and any further contributions that are meant for retirement are being pulled forward to cover your loan. In essence, you are stopping any compounding growth of your retirement assets until the loan is gone. It is not an exaggeration that a $10,000 loan from your 401k could mean $50,000-100,000 less in retirement assets when that day comes. It is not a simple one-to-one trade-off. You need to factor in potential growth until retirement. The maximum length of a 401k loan is 5 years, so every year that you have an outstanding 401k loan is another year that those funds cannot benefit from the wonders of compound interest and growth.
A less talked-about, yet important issue, is that 401k loans are essentially taxed twice. When payments are made to repay the principal and interest of the loan, they are technically made with after-tax money, even if they are coming out of a paycheck (or through payroll). This means that the borrower is effectively paying taxes on the full balance of the loan as it is paid off. Then, since this is a qualified retirement account after all, you will pay taxes on distributions again in retirement.
Some argue that you have to pay the later taxes anyway, regardless of whether there was a loan or not. While true, it doesn’t fix the first round of taxes. Taking a $50,000 loan with a 25% tax rate could mean you will eventually pay $12,500 in taxes just to access this money. From a cost perspective, there may be situations where it becomes cheaper to pay a bank for a loan instead of being taxed on your own your 401k loan.
Are 401k Loans Worth It?
Should you take out a loan from your 401k? The situation always depends, but I would avoid it if possible. There are certainly times when getting a loan (in any form) could be productive, whether that be a new business, investment, project, or similar expense. However, most people look for a loan because they don’t have the cash to cover the expense. The best start is to ask this question: Is this purchase more important than your retirement? If not, I doubt it will be worth significantly handicapping your retirement funds to do so.
If the decision to borrow has already been made, then understanding and exploring all the lending options would be the next step. Borrowing from oneself and keeping the interest sounds preferable, but it comes with many strings attached that must be factored in. It could be, again, if you are okay with the retirement trade-off. Taking on debt is taking on risk. Regardless of whether the funds come from your retirement or your bank, you are still pulling from your future wealth to fund today.
TC Falkner 